Time for investors to get a “toe in the water” with ILS: Aon Hewitt

Institutional investors, such as pension funds, who have been questioning whether now is the time to invest in insurance-linked securities (ILS) and other reinsurance linked investments, should take a “toe in the water” approach and make an allocation now, according to Aon Hewitt.

When is the right time to invest in ILS? Is it at the markets peak, when the returns are most attractive and the reinsurance cycle allows investors to command the highest coupons? After a major catastrophe event, when the market is set to go stratospheric (maybe)? Or right now, when rates and returns are near the bottom of the cycle and the only way (hopefully) is up?

The global investment management research team at Aon Hewitt, the pensions, benefits and investment consultancy arm of insurance and reinsurance broker and advisor Aon, believes that the time is now for investors to make their first allocations to the ILS asset class.

Aon Hewitt feels that ILS (such as catastrophe bonds and other reinsurance linked investments) as an asset class has qualities that should not be ignored. Being fixed income-like in nature, but with very low correlation to other fixed income assets or indeed to other alternative assets, making ILS a quite unique and valuable addition to an investment portfolio.

“ILS is an asset class in its own right and, in our view, this distinction is a key attraction,” Mette Charles, a senior London-based member of Aon Hewitt’s global investment management research team, wrote.

She continued; “ILS has unique attributes which may serve a portfolio well due to the independence of risk which ILS represent. The risk of a catastrophe occurring, such as a hurricane or earthquake, is very distinct from the financial and macroeconomic risks that cause prices in equities and bonds to fluctuate. Thus ILS may help increase portfolio diversification.”

Investors have choice when entering the ILS market, with the ability to target anything from pure catastrophe bonds, to collateralised reinsurance and private ILS, to life, specialty risks and even casualty run-off exposure.

Additionally, the universe of ILS fund managers have grown significantly, providing a range of strategies, funds, styles of management, investment philosophy and of course return targets available. Aon Hewitt advises that investors use a specialist manager, to benefit from the expertise required to “understand all the risks and to crystalise value within the ILS industry.”

And while an asset class like ILS can result in big losses when the major catastrophe events occur, these events are typically 1-in-30 to 1-in-100 year catastrophic losses meaning that they do not happen all the time, which makes the ILS asset class much less volatile than other comparable fixed income or alternatives.

Currently, Aon Hewitt notes, the ILS market does look expensive compared to historical trading levels, due to a range of factors from the lack of major catastrophic events in recent years, to the increasing interest from capital markets investors looking for new sources of yield.

However, “we now have reason to believe that a floor could be found and yields may stabilise,” Mette Charles explains.

She advises institutional investors to get familiar with ILS now, to gain an appreciation of the asset class, and then to make “a small allocation and look to add to allocations as and when the market starts to look more attractive – a toe in the water approach.”

This is sound advice. Waiting for the big event to happen in the current market environment is not advisable. Many investors have already arranged to deploy more capital into ILS on the next major event occurring, with some taking options to guarantee their ability to reinvest or upsize their allocations.

Other investors have agreements with their ILS fund managers that as they are already invested they get first priority to increase their allocations after the next event. Some ILS managers operate policies of going to existing investors first to increase their assets under management, again meaning the queue is already forming for the post-event capital inflows.

So that means sitting it out on the sidelines and hoping to get in with an opportunity to profit after a catastrophe event, is not the best ILS investment strategy right now. Add to the above, that there is no guarantee just how long rates and returns may go up for, with so much capital interested in coming in, that getting in now is likely the best approach.

Of course, ILS managers are in some cases operating closed doors on their funds right now, as they don’t want to accept more capital in case it can’t be deployed profitably. This means that investors who do want to get in right now need to do their homework, meet the universe of ILS managers and ensure they build relationships with as many (who meet their strategy needs) as possible.

It also means that considering allocating to a smaller manager may be worthwhile, just to get this “toe in the water” as it may be much better to be in than not in ILS when the next event happens. That can also give an investor a chance to work closely with smaller ILS managers, helping to drive the strategy for the following allocation.

The key for investors interested in ILS as an asset class is not to get left behind. The advice from Aon Hewitt to get in now is sound, it will allow investors to begin to learn about the asset class, develop relationships with managers and be ready for the next opportunity to allocate more.